Why I Don't Trade Fear Ahead of Earnings

When you trade options, one of your main fears tends to be an event that triggers a move against you. A five-contract trade, opened at $2, can be vaporized in a day on some bad news. $1,000 can be nearly wiped out. It's not easy to recover from that, either. I've been there many times, and it stings. At the same time, if we use good risk management and control, these events will inflict only minimal damage.

You may ask: "Bob, why even go there at all? The market is open all other days aside from when earnings are released, so why go through the agony of a binary event?" These are good questions to ask, but let's break this process down a bit in order to glean a better understanding.

As always, let's start with the charts. In order to find my trade setups, I use the technical patterns that have historically worked for me -- these formations are often what show me where stock acceleration, momentum and trends are starting to develop. If earnings happens to merge with a ripe chart pattern, then so be it. The result might even constitute a catalyst to drive more buyers into a stock.

Have you ever wondered why a stock might perform well even after it misses on estimates or provides poor guidance? How about the ones that beat on earnings and get hammered mercilessly the following day? It can make you scratch your head in amazement, can't it?

Well, I have personally had some of my best trade results after an earnings release. In February we were long LinkedIn (LNKD) calls into earnings and the stock exploded afterward, and the same happened in Whole Foods (WFM) this week. Rackspace (RACK) likewise ran up into earnings -- but, in that case, the patterns became bearish post-earnings, which primed the stock well for a two way trade (strangle). That worked out very nicely for us.

The technicals reveal certain patterns that arise again and again -- but should we just avoid playing stocks or options around earnings? Most companies release their quarterly activity four times a year, so why would you panic each time? Yes, options pricing obviously is skewed toward the high side around earnings in the short term, especially in high-beta names that could move heavily. But, after these events stocks tend to simmer down, or we at least see a decline in implied volatility.

Did you see the action and reaction of IBM (IBM) before and after earnings? The shares had a big run-up into the report and a huge drop just after, returning right back to where it had been before the announcement.

So play the game the way you see fit. Don't let news, events and reactions influence your decision-making process. In the long term you're probably be proven right -- just sit tight.

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